Will the RBI policy calm bond markets? Here's what analysts think

High borrowing numbers in the budget as well as absence of any steps to facilitate global bond index inclusion roiled the domestic markets, pushing the yield on the benchmark debt to 6.8

As economic recovery gains ground amid less intense coronavirus (Covid-19) waves, global central banks, including the Reserve Bank of India (RBI), have their task cut – to gradually withdraw the easy money, or liquidity support when it unveils the monetary policy decision on Thursday. 

Since the announcement of the Budget on February 01, money markets have been nervous. High borrowing numbers in the budget as well as absence of any steps to facilitate global bond index inclusion roiled the domestic markets, pushing the yield on the benchmark debt to two-year high of 6.8 per cent. This comes at a time when global central banks – the US Federal Reserve (US Fed) and the European Central Bank (ECB) – are looking to hike rates soon. Bank of England, on the other hand, has already hiked rates recently. This nervousness in the bond markets, analysts say, may make Shaktikanta Das’ task even more challenging.

"G-sec market shows nervousness around impending policy actions and a possible supply-demand mismatch in the absence of RBI. Against this backdrop, even a reverse repo hike or a stance change could disturb the market further. Thus, cautious policy treading and communication will be the key," wrote Madhavi Arora, lead economist at Emkay Global in a co-authored report with Hitesh Suvarna.

Analysts believe recent auction cancellations due to high government cash balance could help soothe market nerves, but a huge supply next fiscal (even with some upside surprise on revenue stream) will require the RBI’s invisible hand in a more visible fashion, implying return of pre-committed G-sec Acquisition Programme (GSAP).

"This, however, will interfere with the RBI’s aim of liquidity normalization, balance sheet preservation and a possible change in stance and repo hike(s) ahead, starting with a fixed RR hike. Conversely, a further increase in term premia could percolate to credit markets and impede the policy aim to push trend growth by encouraging private capex," analysts at Emkay Global believe.

In recent years, the RBI has absorbed 25 per cent of net market borrowings. However, for some time, the RBI essentially stopped its G-sec purchases in a bid to normalise excess liquidity. Now with yields spiking, RBI’s challenge mounts.

"On one hand, it might be uncomfortable with a spike in yields, but on the other, it is trying to normalize excess liquidity. Navigating this dilemma becomes even more challenging with the Fed/ECB on a tightening path. Thus, RBI’s commentary around these issues will be keenly watched," said Edelweiss Securities' report.

Nonetheless, analysts and the Street are baking-in, at most, a 25-basis point (bps) hike in reverse repo rate – the rate at which RBI pays interest to commercial banks for parking their funds with it – along with holding the accommodative stance.

Those at Brickwork Ratings expect the central bank to hike policy rates in its April 2022 policy meeting, as growth remains fragile and bond yields are trading higher. 

10-year bond yields have risen since the December policy meeting, while tightness in liquidity has led to some short-term market rates rising above the Repo Rate. However, the pace of the adjustment in market pricing may not be liked by the RBI.

Given this, Rahul Bajoria, chief India economist, Barclays said if these events are left to continue it would only be a matter of time before trends in market rates were transmitted into retail lending and deposit rates. "In our view, maintaining control over broader financial conditions in the economy requires the RBI to remain an active presence in markets," he added. 

Barclays expects the central bank to keep the Repo rate on hold, but to narrow the policy rate corridor by undertaking a 20-25bp hike in the Reverse Repo rate partly. It also expects the RBI to replenish this reduction in banking liquidity by undertaking some bond purchases without necessarily stoking inflation. Alternatively, it thinks the RBI could hike the Cash Reserve Ratio (CRR), which would also provide room to undertake OMO purchases in a liquidity neutral manner.